When it comes to making investment decisions, tax treatment is rarely the most important factor. However, it is an area that:
- Affects your overall rate of return.
- Gives you some level of control.
After all, it’s easier to pursue tax-efficient investments than it is to try to predict which will have the best rate of return over time.
With this in mind, these five strategies can help you minimize the tax burden of your investment portfolio.
Are you contributing the maximum limit on a qualified retirement plan? If not, you should strongly consider bumping up what you set aside. Not only will you grow your assets, but it will also reduce your tax bill.
Qualified plans that defer income taxes and offer tax deductions for contributions are ideal for investments such as:
- Mutual funds.
- Taxable bonds.
These investments are generally long-term. This allows you to make more aggressive decisions without worrying about immediate capital gains taxes.
If your employer offers a 401(k) plan, it's best to contribute as much as possible. The sooner you begin and the more you contribute, the better off you'll be when it's finally time to hang up the white coat.
Contributions also lower your taxable income by the amount you set aside each year. The current annual maximum is $18,500 for people under age 50 and $24,500 for people 50 and over. However, high-earners like physicians can set up a deferred compensation plan to set even more aside.
In addition to the tax deduction for contributions, 401(k) plans grow on a tax-deferred basis. This means you won’t pay any taxes on the account assets until you begin withdrawing funds in retirement.
Whether you have access to an employer 401(k) plan or not, you should capitalize on the perks of an IRA. You can open an IRA through banks, mutual fund companies and brokerage firms. These plans allow you to save up to $5,500 annually — $6,500 if you’re 50 or older — for retirement.
Like a 401(k), contributions to a traditional IRA are tax-deductible. Your assets will grow tax-deferred until you begin making withdrawals.
One option is a Roth IRA. With a Roth IRA, there is no tax deduction for contributions. However, what you take out in retirement will be tax-free income as long as you meet certain qualifications.
An IRA are especially convenient if you switch employers. It will allow you to roll your accumulated 401(k) assets into your own retirement plan without any expenses or tax penalties.
Exchange-traded funds (ETFs) and index funds offer tax advantages over actively managed mutual funds. These funds mimic a market index, such as the S&P 500. This means the assets within the fund are not bought and sold as often as those in actively managed funds.
Meanwhile, actively managed funds are managed by a team seeking to generate a maximum rate of return. The frequent buying and selling of fund assets leads to more capital gains. These are passed onto those who own shares of the fund.
However, every time an active fund sells a holding it incurs taxes and fees, which diminish the fund's performance.
The main appeal of actively managed funds is they allow you to beat the market. But this is the exception, not the rule. That's why a busy doctor is much better off investing in passively managed mutual funds that mirror the market.
You may be able to generate tax-free income by investing in municipal bonds. These bonds pay income that is exempt from federal taxes. In addition, bonds issued by your state of residence typically provide income that is exempt from state income taxes as well.
While the yield is lower on tax-free bonds than on taxable bonds, the tax-free status of municipal bonds can be an advantage for investors in higher tax brackets.
Tax-loss harvesting is an investment strategy that can minimize your tax burden. It involves selling an asset that has lost value to offset the capital gains you will owe on a sold asset that has gained in value.
This strategy is often used during market downturns. It allows you to carry any losses you do not use in one tax year forward into future tax years.
Taxes are tricky --- especially when factoring their treatment into your investment decisions. When it's time to do so, consider the various strategies surrounding:
- Mutual funds.
- Tax-exempt bonds.
- Offsetting gains with losses.
Be sure to get your tax and investment advisers in the same room for this one.
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Joel Palmer is an award-winning journalist, corporate copywriter, and marketing specialist with over two decades of professional experience. He writes compelling, authoritative, and original content for companies and organizations across a wide range of industries, from financial services and real estate to government and software development. In addition to having written thousands of stories, his diverse portfolio also includes six ghostwritten books.